Hoover Institution Experts: Our Growing Economic Mess

Matthew Glans is a Senior Policy Analyst at The Heartland Institute. Glans joined the staff of The Heartland Institute in November 2007 as Heartland’s Legislative Specialist on Insurance and Finance. Glans’ responsibilities include interacting with elected officials and staff on insurance and finance issues; tracking new legislation; and drafting responses to emerging issues via talking points, news releases, and op-ed pieces, with the goal of educating legislators and informing them about free-market ideas.

Glans earned a Master’s degree in political studies from the University of Illinois at Springfield. He also graduated from Bradley University with a Bachelor of Arts degree majoring in political science. Before coming to Heartland, Glans worked for the Illinois Department of Healthcare and Family Services in its legislative affairs office in Springfield. Glans also worked as a Congressional Intern in U.S. Representative Henry Hyde’s Washington D.C. office in 2004.

George P. Shultz, Michael J. Boskin, John F. Cogan, Allan H. Meltzer and John B. Taylor senior fellows at the Hoover Institution at Stanford University argue that the most serious missteps by the U.S. government revolve around severe mismanagement of monetary policy by the Federal Reserve and poor budget and spending policy by the Obama Administration.

The authors’ primary focus is on the Federal Reserve and its increasing role in both micromanaging the economy through interest rate manipulation and its growing burden of federal debt.

“Did you know that, during the last fiscal year, around three-quarters of the deficit was financed by the Federal Reserve? Foreign governments accounted for most of the rest, as American citizens’ and institutions’ purchases and sales netted to about zero. The Fed now owns one in six dollars of the national debt, the largest percentage of GDP in history, larger than even at the end of World War II.”

They also question the Fed’s policy of paying banks for holding more money in their reserves. Not only does this essentially incentivize banks that hold their money in reserve instead of lending it out to consumers (the stated goal of recent Fed policy), the policy creates a massive subsidy to the banks which is not approved by any elected officials, just the unelected Federal Reserve Board. In addition, by keeping interest rates low in the long term, the Fed is cutting into the real interest rates and diminishing the value of the savings of those who have saved for years for retirement.

”Did you know that the Federal Reserve is now giving money to banks, effectively circumventing the appropriations process? To pay for quantitative easing—the purchase of government debt, mortgage-backed securities, etc.—the Fed credits banks with electronic deposits that are reserve balances at the Federal Reserve. These reserve balances have exploded to $1.5 trillion from $8 billion in September 2008.

The Fed now pays 0.25% interest on reserves it holds. So the Fed is paying the banks almost $4 billion a year. If interest rates rise to 2%, and the Federal Reserve raises the rate it pays on reserves correspondingly, the payment rises to $30 billion a year. Would Congress appropriate that kind of money to give—not lend—to banks?

The Fed’s policy of keeping interest rates so low for so long means that the real rate (after accounting for inflation) is negative, thereby cutting significantly the real income of those who have saved for retirement over their lifetime.”

This vast expansion of bank reserves could have dire side effects, ranging from inflation to an even deeper credit freeze then the one we are currently experiencing. The editorial raises serious questions over whether the Fed has the capability to handle large scale fiscal and monetary issues in the future.

“This large expansion of reserves creates two-sided risks. If it is not unwound, the reserves could pour into the economy, causing inflation. In that event, the Fed will have effectively turned the government debt and mortgage-backed securities it purchased into money that will have an explosive impact. If reserves are unwound too quickly, banks may find it hard to adjust and pull back on loans. Unwinding would be hard to manage now, but will become ever harder the more the balance sheet rises.”

While the Federal Reserve is a big part of the current and future problems the country will have to face, the increasing debt that the government is creating is another that legislators and regular citizens cannot ignore. As our non-discretionary spending under Social Security, Medicare and Medicaid increases without necessary reforms being implemented, the risk of being unable to cover these costs without dramatic tax grows. The authors argue that soon even the interest on U.S. debt may overwhelm existing spending levels. The end result? Significant tax increases for all taxpayers.

“President Obama’s budget will raise the federal debt-to-GDP ratio to 80.4% in two years, about double its level at the end of 2008, and a larger percentage point increase than Greece from the end of 2008 to the beginning of this year.

Under the president’s budget, for example, the debt expands rapidly to $18.8 trillion from $10.8 trillion in 10 years. The interest costs alone will reach $743 billion a year, more than we are currently spending on Social Security, Medicare or national defense, even under the benign assumption of no inflationary increase or adverse bond-market reaction. For every one percentage point increase in interest rates above this projection, interest costs rise by more than $100 billion, more than current spending on veterans’ health and the National Institutes of Health combined.

Worse, the unfunded long-run liabilities of Social Security, Medicare and Medicaid add tens of trillions of dollars to the debt, mostly due to rising real benefits per beneficiary. Before long, all the government will be able to do is finance the debt and pay pension and medical benefits. This spending will crowd out all other necessary government functions.

What does this spending and debt mean in the long run if it is not controlled? One result will be ever-higher income and payroll taxes on all taxpayers that will reach over 80% at the top and 70% for many middle-income working couples.”

The Fed’s current policy has focused primarily on the dumping of new cash into the money supply in order to induce lending through a process called quantitative easing. Given the inability of the Fed to encourage lending through its ordinary measures, with an interest rate near zero, the Fed has taken to periodically buying financial assets from commercial banks and other private institutions with newly printed money in order to increase the money supply and hopefully provide banks with more liquidity. Where the real concern comes in, according to the authors, is the unreliability of QE has an economic tool and the power it places in an unelected body, the Fed.

“The Fed is adding to the uncertainty of current policy. Quantitative easing as a policy tool is very hard to manage. Traders speculate whether and when the Fed will intervene next. The Fed can intervene without limit in any credit market—not only mortgage-backed securities but also securities backed by automobile loans or student loans. This raises questions about why an independent agency of government should have this power.

When businesses and households confront large-scale uncertainty, they tend to wait for more clarity to emerge before making major commitments to spend, invest and hire. Right now, they confront a mountain of regulatory uncertainty and a fiscal cliff that, if unattended, means a sharp increase in taxes and a sharp decline in spending bound to have adverse effect on the economy. Are you surprised that so much cash is waiting on the sidelines?”

The solutions, they argue are strong market based reforms that cut spending and taxes while also expanding the tax base. One point they make very clear, staying on the current path is tantamount to driving the economy right back into a financial crisis.

“The problems are close to being unmanageable now. If we stay on the current path, they will wind up being completely unmanageable, culminating in an unwelcome explosion and crisis.

The fixes are blindingly obvious. Economic theory, empirical studies and historical experience teach that the solutions are the lowest possible tax rates on the broadest base, sufficient to fund the necessary functions of government on balance over the business cycle; sound monetary policy; trade liberalization; spending control and entitlement reform; and regulatory, litigation and education reform. The need is clear. Why wait for disaster? The future is now.”

The authors do an incredible job of dissecting the government’s rampant mismanagement of the country’s economic and monetary policy, while asking important questions about who should be holding this power. The Federal Reserve, an unelected agency holds significant power over the economic fate in our country, power that should be in the hands of elected officials who can be held responsible for any mistakes they make.